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Financial derivatives have gone mainstream lately as the most popular trading platforms catering to retail investors have started to provide access to these fascinating instruments.
These derivatives have been designed with particular purposes for businesses and corporations, but they can also be used to speculate in the financial markets.
Even though that may sound enticing, the complexity of their structure and characteristics make them risky as well and investors should fully understand how these instruments work before they start operating with them.
In this article, we will be focusing on one of the most popular derivatives among retail traders: futures. Throughout this piece, we will discuss what futures are, how they work, what the benefits and disadvantages of using them are, and how you can trade them.
What Are Futures?
Futures are a financial derivative that gives the holder the right and obligation to buy or sell a certain underlying asset at a certain price once the contract has expired. These instruments are traded in a formal exchange, and they were initially conceived to protect producers and end customers from sharp price swings that could affect their profitability.
Those who sell (write) a futures contract seek to secure the price at which they will be selling the underlying asset in the future. Meanwhile, those who buy a futures contract are attempting to secure the price at which they will be buying the underlying asset in the future.
How Futures Trading Works
Futures typically trade in an exchange such as the Chicago Mercantile Exchange (CME) and the Intercontinental Exchange (ICE). These institutions oversee making sure that contracts are settled while also fostering liquidity and price transparency.
These instruments have certain specifications that tend to be standardized. These specs, as they are often referred to, detail the number of units (size) per contract, the currency in which the price is quoted, the instrument’s trading hours, the settlement method, and other important stipulations that are used to minimize disagreements and confusion among the parties involved.
Differently from options, futures entitle the holder to take delivery of the underlying asset on the date on which the contract is settled. If an investor is not willing to take delivery of said asset, the contract must be sold before the expiration date.
Futures can be classified based on their underlying asset. Here’s a summary of the most common types of futures contracts:
- Financial futures: The underlying asset is a financial asset where the contract tracks the value of a certain financial indicator such as an index or the interest rate of a bond.
- Commodity futures: These are the best-known futures contracts. They entitle the holder to receive the underlying asset, whether that is gold, oil, wheat, or corn, once the contract expires.
- Currency futures: They are primarily used by companies to hedge their exposure to foreign currencies by agreeing to take delivery of a certain amount at a future date. They can also be used to speculate on the forex market.
- Cryptocurrency futures: This is a brand new category that emerged with the rise of digital assets — primarily Bitcoin. These futures entitle the holder to take delivery of certain digital assets once the contract expires.
How to Trade Futures
In this section, we will be providing you with a step-by-step guide in case you will be trading futures for the first time.
Step 1: Understand the Risks
Futures are financial derivatives whose price is set by the market based on a handful of variables that affect the appraised value of the underlying asset at a certain point in time.
Since these contracts are inherently different than trading the asset directly — i.e., stocks, bonds, foreign currencies, or cryptos — investors should acknowledge the risks involved when dealing with futures.
The first risk is the use of leverage. Most contracts are structured to deliver large quantities of the underlying asset rather than trading on a per-unit basis.
For example, futures of the West Texas Intermediate (WTI) — oil futures — represent 1,000 barrels per contract meaning that a trader would need at least $8,000 to be able to buy a single contract if the price of oil is trading at $80 per barrel.
To make futures trading accessible to retail investors, brokerage firms allow traders to use borrowed funds — also known as margin trading — so they can place their trades. When high amounts of leverage are involved, even the tiniest fluctuation in the price of the contract could lead to sizable losses, and that is one of the most important risks that investors should understand before dealing with these instruments.
Moreover, when a futures contract expires, the person holding the contract on the settlement date must take delivery of the underlying asset. An investor must take action on any futures contract that is expiring soon to either settle the transaction in cash, which involves a gain or a loss depending on the cost basis and final price at settlement, or roll over the contract to the next available expiration date.
Rolling over a contract typically generates a trading fee for both closing the soon-to-be expired contract and opening a new position.
Finally, the market for certain futures contracts can be in backwardation or contango. A market is in contango when the price of the current contract (the one that will be due the soonest) exceeds the spot price. This happens when storage costs are high or when the market expects that the price will experience significant positive volatility in the near term.
Meanwhile, a situation of backwardation is when the price of the current contract is lower than the spot price. This is a situation that favors speculators but typically reflects the fact that the market expects that the spot price will decline in the near future.
A change in the market’s structure from contango to backwardation and vice versa is another risk that futures traders face and must acknowledge.
Step 2: Develop a Strategy
Turning a profit when trading a financial asset requires the adoption of a system that produces an attractive win rate through the use of objective and tangible data that leads to the execution of potentially profitable transactions.
If the purpose of a futures trade is to hedge against a potential decline in the stock market, or any other asset class for that matter, the strategy will consist of short-selling a futures contract to earn money if such a downturn occurs.
On the other hand, if the trader’s strategy is to turn a profit by speculating in the markets most operators use technical analysis such as price action indicators, charting tools, and pattern identification software to place trades based on their findings.
Another possibility is to focus on the fundamentals of each market to anticipate upcoming price swings by analyzing supply and demand dynamics. This strategy is typically employed when trading commodity futures.
Step 3: Open a Futures Trading Account
Many brokerage firms are providing access to the futures market to retail investors these days. However, since this market is fairly complex considering the significant risks involved, most of these companies have established protocols that aim to prevent unwary investors from dealing with financial instruments that they don’t fully understand.
For this reason, opening a futures trading account can be a bit more difficult and may require the completion of further steps compared to opening a traditional investment account.
In most cases, brokers may require a higher minimum deposit while also asking investors to fill a questionnaire that seeks to assess their knowledge about how the futures market works.
They will also require further information about the trader’s financial situation such as their net worth, goals, and risk tolerance.
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Step 4: Select a Futures Market to Trade-In
Once a futures trading account has been opened, it is time to select the instruments and markets that the trader will specialize in. For stock traders, the most popular futures contracts are those that track the value of a certain index such as the E-mini futures of the S&P 500 and Dow Jones Industrial Average. These two contracts are offered by the CME Group.
Meanwhile, for those who prefer to speculate on the price of a certain commodity, it is important to choose among the vast number of alternatives to focus on perhaps one or two assets as each market is driven by entirely different variables that affect the supply and demand for these materials. The same goes for precious metals such as gold, silver, and palladium.
Finally, it is also possible to speculate on the forex market by using currency futures or traders can also take advantage of the recently introduced Bitcoin (BTC) and Ethereum (ETH) futures to take a gamble by trying to forecast where the price of these popular digital assets is headed.
Step 5: Understand Margin Requirements & Fees
The price of futures is typically expressed on a per-unit basis. For example, the price of oil futures typically reflects the value of one barrel of crude. However, the value of a single contract is the result of multiplying the price per unit by the contract unit.
In the case of WTI futures, the contract unit is 1,000 barrels. Therefore, if the price per barrel is standing at $80, the value of one contract will be $80,000.
To estimate how much capital a trader would need to operate with certain kinds of futures, it is important to know the maximum leverage permitted by the broker and the minimum stop-loss level possible.
In some cases, the minimum capital required could be $500 for mini contracts such as those of the major stock indexes. However, in other instances where the size of the contract and its overall value is rather high, the minimum capital could rise to thousands of dollars.
Most broker-dealers charge either a fixed fee per contract to trade futures or they may opt to charge a percentage-based commission on the value of each trade for both buy and sell orders.
Margin requirements also vary from one broker to the other. The initial margin is the minimum amount of equity that traders must have in their accounts to open a position. If the value of the position’s equity moves below the maintenance margin, a margin call will be triggered.
As a result of this situation, traders will have to deposit more money into the account or they will face the forced liquidation of some of their open positions.
Step 6: Place and Manage Your Futures Trades
Brokerage firms nowadays have created user-friendly trading interfaces through which investors can easily locate and place a trade order. In the case of futures, the ticker symbols might look different than traditional stock tickers.
In any case, users will typically be prompted to indicate the number of contracts they would like to buy, the stop price at which the position will be automatically closed, and the maximum price they will be willing to pay to open the position. In some cases, a take-profit level may also be added to the order.
The stop price and take-profit levels are typically identified after analyzing the price chart of the instrument at hand, and they are a critical part of any trader’s systems. In this regard, investors can take advantage of today’s advanced interfaces to automate most of their operations so they can take emotions off the table and focus on following the system and strategy they have set forth for this activity.
Important Futures Trading Terminology
If you will be engaging in futures trading, it is important to understand the basic terminology that brokers and information providers will be employing when citing different developments concerning this market.
Here’s a brief glossary that explains what some of the most widely used terms mean.
Leverage refers to how much money can be or is being borrowed by the trader to open a position for a certain futures contract. Leverage is usually expressed as a ratio — i.e., 20:1 or 100:1 — and this number indicates how many dollars are being borrowed for every dollar of the trader’s capital that is being allocated into the position.
The trading sessions in the futures market tend to outlast those of the equity markets. Oil futures, for example, trade from Sunday to Friday from 6:00 a.m. to 5:00 p.m. CT. Any price quoted outside regular trading hours is typically referred to as the extended-session price or the after-hours activity. In some cases, this term is also used to refer to how the market is fluctuating before or after a certain equity market has opened.
The liquidity of a market refers to the availability of contracts from both buyers and sellers. A highly liquid market has narrow bid/ask spreads due to elevated trading volumes — lots of buyers, lots of sellers. Meanwhile, a relatively illiquid market has fewer participants, and trading volumes tend to be low, meaning that bid/ask spreads tend to be wider; thus, it becomes more difficult to find buyers and sellers for the futures contract at different price levels.
Hedging is a strategy that consists of using futures contracts to protect a portfolio against certain negative events. One example of this involves using E-mini futures of certain stock indexes such as the Dow Jones Industrial Average to hedge a stock portfolio from a short- or mid-term decline in equity valuations. By short-selling a futures contract on these indexes, the investor can turn a profit that partially offsets the losses experienced by the stock portfolio during a certain period.
The size of a futures contract indicates how many assets will be delivered once the contract is settled. In the case of WTI futures (oil), the contract unit is 1,000 barrels of crude.
The contract value is the result of multiplying the price per unit of the underlying asset, commodity, or good by the contract unit.
The tick size indicates the minimum price fluctuation that the contract can experience. This is typically expressed in decimal points for per-unit prices, or it can be a relatively higher figure if expressed in terms of the contract value. In the case of WTI futures, the tick size is $0.01 per barrel or $10 per contract.
Example of a Futures Trade
Let’s say an investor believes that the US equity market is going to experience a correction in the following two months. Futures can be used in this scenario to hedge a stock portfolio against this potential decline.
The way to do this is short-selling some E-mini S&P 500 contracts, which track the value of the popular broad-market US stock index. Let’s assume that the price of the index stands at $4,479.75, and the contract unit is $50. This means that one contract is valued at $223,987.50.
Most brokers require that a trader puts up capital ranging from 2% to 12% of the total value of the trade to open a position. If we assume that the broker will impose a 2% initial margin requirement, the account must have buying power equal to $4,479.50 to open a position.
To complete the trade, the trader must set a stop price and a take-profit price at which the position will be closed to both prevent losses and lock in any potential gains.
Benefits of Futures Trading (Pros)
- Futures are traded via well-regulated and properly organized exchanges.
- There are many different types of futures contracts covering an ample spectrum of assets including commodities, cryptocurrencies, and stock indexes.
- Most brokerage firms nowadays offer access to the futures markets and trading commissions are relatively low.
- Futures can be used to hedge portfolios.
- They are a good vehicle to speculate on sophisticated markets.
Downsides of Futures Trading (Cons)
- The minimum deposit required to open a futures trading account is quite higher than that of a regular investment account.
- The futures market is complex and the dynamics that influence the price of some of the assets covered by these derivatives can be hard to grasp.
- Failing to implement appropriate risk management strategies when trading futures can lead to sizable losses.
Frequently Asked Questions (FAQs) on Futures Trading
The following is a list of answers to the most frequently asked questions we get on the topic of futures trading.
How Much Money Do You Need to Trade Futures?
The initial margin requirement for trading futures varies from one broker to the other. As a rule of thumb, a minimum of $5,000 might be needed to trade most of the futures contracts available. That amount may go up to $10,000 for certain commodities.
Is It Profitable to Trade Futures?
As with most activities, trading futures profitably involves developing a system that guarantees a high win rate along with developing the skillset and appropriate mindset required to follow this systematic approach. In summary, profits can be made out of this activity, but it will not be easy.
Are Futures a Type of Derivative?
Yes. Futures are considered a derivative as their value is “derived” from the price of an underlying asset.
What Happens if You Hold a Futures Contract Until Expiration?
It depends. In some cases, this will obligate the holder to take delivery of the underlying asset according to the terms and conditions of the contract. In others, the contract might be settled in cash, meaning that the holder will either receive or pay the difference between the cost basis and the settlement price.
What Assets Can Be Traded Using Futures?
The list of assets for which futures are offered is quite long. There are commodity, currency, cryptocurrency, stock index, and non-traditional financial futures. Some of the most popular and well-known contracts are oil, gold, corn, Eurodollar, and E-mini S&P 500 futures.
Futures trading is one of the most sophisticated activities in the financial markets. In the past, only large institutions and hedge funds participated in this market, but brokerage firms have opened access to retail investors recently.
If you were unfamiliar with how futures work or how you could operate with them, we hope to have introduced you to the basics of this fascinating market. Make sure you fully understand how these instruments work before you start trading them. Best of luck!
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Alejandro is a financial writer with 7 years of experience in financial management and financial analysis. He writes technical content about economics, finance, investments, and real estate and has also assisted financial businesses in building their digital marketing strategy. His favorite topics are value investing and financial analysis.